Baby Step Three: Save 3-6 Months of Expenses for Emergencies

Dave Ramsey’s third baby step is to save three to six months of living expenses for emergencies. That prompts people to ask if they should have three months worth of expenses or six months. Well, it depends...

It’s definitely more conservative to have those six months of living expenses saved up for an emergency situation. People who are in a career where they feel their job is not fully secure, or people who are paid by bonuses or commissions that can’t be relied upon, those people should save closer to six months of expenses. But if you have a pretty stable paycheck and you feel like you would be comfortable just cutting down your living expenses if something happened, three months of expenses could do the trick. So it’s really up to you to decide what you want your emergency savings to be.

I had a client who I started working with when he lost his job. He’d been with the company for 15 years and didn’t see it coming, but they were downsizing and they decided to lay off some of their best people because those were the people they were paying the most. He had a six-month emergency fund and it allowed him to not be stressed financially, or to have to dip into his retirement accounts. He didn’t have to rack up any debt and he could spend six months finding a good job. It gives you a good buffer and you never know when you might need that.

The point of using three to six months as a measuring stick is based on the idea that if you lost your job, you would have savings to fall back on while you found another one. Or if you were disabled or were sick for a while, you would have savings to see you through until recovery. But the emergency fund is also for surprises such as a leaky roof or an unexpected car repair. So you also need to consider those types of expenses. Making sure you have enough money to cover health insurance and car insurance deductibles, be able to replace appliances that might break down, car repairs, etc. If you own a home, could you cover repairs for a flood? Or repair a roof?

Another point that some people get confused about is that a down payment on a house is not an emergency. Don’t use your emergency fund for a down payment on a house. You need an emergency fund if you’re going to buy a house. I had a friend who bought a house and a few weeks later the water heater broke and flooded their basement. They spent a couple thousand dollars on a house they had just bought, cleaning up a flood and fixing a water heater. So once you own a home you need to look at having a larger emergency fund.

A lot of people meet with me while they’re working on baby step three because they are preparing for the next step—baby step four—and want to take time get prepared for their future financial plan. When I meet with people, some of them want to know if they should be investing their emergency fund in something other than the savings account at the bank. No, no, NO! An emergency fund should be as liquid as possible so you are ready to use it when the emergency arises.

Your Next Action Items:

1. Find the right emergency savings account. Like Dave Ramsey teaches, you should consider your emergency savings as insurance. You pay for your home insurance. You pay for car insurance in case something catastrophic happens. With your emergency fund, you’re foregoing the interest you could be receiving on that money as insurance so that the money is available when you need it.

Your emergency fund should be in an account that is separate from your other savings and checking accounts. Consider an account you don’t look at all the time so you’re not seeing this chunk of money that you shouldn’t dip into except for emergencies.

2. Review your financial plan details. The third baby step is a good time to set up an appointment with your financial advisor. While your emergency savings grows we can get your plan in place to start investing in baby step four. Let's find a time to meet and get the basic questions out of the way and start moving forward.